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You Don’t Know What You Don’t Know: Challenges of Doing Business in New York State: Owner Liability for Wages

New York State Bar Association Corporate Counsel & Business Law Sections' Joint Fall Program Doing Business in New York State: Challenges & Opportunities

October 14, 2016 You Don't Know What You Don't Know: Challenges of Doing Business in New York State

OWNER LIABILITY FOR WAGES By

Thomas M. Pitegoff LeClairRyan New York, NY 212-34-5032

www.leclairryan.com tom.pitegoff@leclairryan.com BCL Section 630 Section 630 of the New York Business Corporation Law ("BCL") provides that the ten largest shareholders of a New York corporation whose shares are not publicly traded "shall jointly and severally be personally liable for all debts, wages or salaries due and owing to any of its laborers, servants or employees other than contractors, for services performed by them for such corporation." 1 The employee seeking recovery under Section 630 must first give written notice to the shareholder or shareholders that he intends to hold them liable under that section. The notice must be given within 180 days after the employee's services terminate, or if the employee demands to examine the record of shareholders (under paragraph (b) of Section 630), then notice may be given within 60 days after the employee is given the opportunity to examine the record of shareholders. The employee must first bring a successful action against the corporation that is unsatisfied. A shareholder who has paid more than his pro rata share is entitled to contribution pro rata from the other shareholders liable under Section 630 with respect to the excess amount paid. New York first specifically protected employee wages in the Manufacturing Corporations Act of 1848.2 Joint and several shareholder liability for wages was then embodied in Section 71 of the New York Stock Corporation Law, the predecessor of the Business Corporation Law.3

The Business Corporation Law was enacted in 1961 and became effective in 1963.4 Section 630, a revised version of Section 71 of the prior law, was added for the first time in the final draft of the BCL which was introduced three months before it was enacted.5 The time within which an employee must notify the shareholders of a wage claim under Section 630 was increased from 90 days to 180 days in 1984. Since 1984, Section 630 has not been changed. Recent Extensions of Liability In November 2015, BCL Section 630 was amended to extend personal liability for wages to shareholders of closely held corporations formed in other states and qualified to do business in New York State. The ten largest shareholders were made personally liable for unpaid services performed in New York State.6 The memorandum in support of this bill indicated that the bill "ends discrimination against New York corporations and in favor of foreign (out of state) corporations insofar as liability for unpaid wages is concerned." Query: Will this amendment to BCL Section 630 incentivize businesses to establish their physical offices in other states and not to have employees in New York? Separately, in 2014, the New York Limited Liability Company Law ("LLCL") was amended to extend personal liability for wages to members of limited liability companies in New York State. Section 609 of the LLCL was amended by the addition of subdivisions (c) and (d), making the ten members with the largest percentage ownership interest personally liable for wages and salaries of employees.7 Problems with the Law These laws would appear to discourage businesses from forming in New York State and from locating in the state. They might act as an impediment to business and employment in the state. Most entrepreneurs and angel investors assume that when they invest capital in a corporation or limited liability company, they will incur no personal liability at all. Personal liability for wages would likely come as a shock to many if not most New York entrepreneurs and angel investors. New York is only one of two states that make shareholders personally liable for wages. No other state makes limited liability company members personally liable for wages. These laws create strict liability for the ten largest owners. Passive owners are liable jointly and severally and regardless of knowledge or fault. Moreover, they target corporations whose shares are not publicly traded. Startup companies are not publicly traded.

This type of wage protection is an anachronism. Workers are protected today by veil piercing principles and by labor and bankruptcy laws that did not exist when New York first imposed shareholder liability for wages in 1848. These laws are exceptions to the nearly universally recognized principle of shareholder limited liability. Limited liability is a bedrock principle of corporate law for a reason. The success of the corporate entity as a form of business results from the concept of limited liability for the investors along with perpetuity of existence and transferability of shares.8 Limited liability encourages investors to take entrepreneurial risks. This promotes the formation and growth of new business entities, which is socially desirable.9 Limited liability allows investors to diversify. Normally, diversification reduces risk. But the possibility of any one company yielding a catastrophic liability discourages diversification.10 With more risk, an investor would want a higher return on his or her investment, which limits the company's ability to reinvest profits or to compensate management and employees. Higher risk increases the cost of capital. Limited liability facilitates investment, making more capital available at a lower cost.11 The Historic Trend is Toward Limited Liability The principle of limiting liability to the amount invested in the company developed over the course of the nineteenth century.12 New York13 and most other states imposed double liability on shareholders between 1810 and 1860, in an amount equal to the par value of the shares purchased.14 By the late nineteenth century, however, the principle of limiting shareholder liability to the amount invested became a fully developed principle. At the same time, a number of states had laws similar to New York's law making shareholders personally liable for wages. A few of those state laws remained in effect

8 "The principle of limited liability is associated with the dramatic growth of economic activity in the United States and has received extravagant praise as a beneficent policy with profound economic implications." PHILLIP I. BLUMBERG ET AL., BLUMBERG ON CORPORATE GROUPS, 3.02 (2d ed. 2005). 9 See BLUMBERG, Id. at 5.03[A].

10 "Without limited liability, investing in one more corporation does not reduce risk. Catastrophic liability in any company within an investor's portfolio would eliminate the investor's personal wealth. Adding a corporation to a portfolio causes an increased probability of financial destruction. Rather than investing being analogous to many small gambles, unlimited liability restores to each investment the possibility of being a huge disaster. Limited liability is necessary for diversification and reduction of the financial risk it entails."

through the mid-20th century. Today, only Massachusetts15 and New York still impose personal liability for wages. Similar laws in Pennsylvania, Tennessee and Michigan were repealed in 1966, 1969 and 1973 respectively. A similar law in Wisconsin was repealed in 2005.16 Limited Liability Companies Recognizing the benefits of limited liability, states have expanded the types of entities that have this feature to limited liability companies and limited liability partnerships. The limited liability company operates in a manner similar to a partnership but offers limited liability and the possibility of avoiding taxation at the corporate level in a more flexible and accessible manner than a subchapter S corporation. In 1977, Wyoming was the first state to enact a limited liability company law. The New York LLCL was enacted in 1994. By 1997, all fifty states in the U.S. had limited liability company laws. Today, the number of new limited liability companies far exceeds the number of new corporations being formed across the country each year.17 Imposing Personal Liability on Passive Owners for Wage Liability is Unfair In addition to discouraging investment and employment in New York State, the imposition of strict liability for employee wages on the largest owners is unfair. The shareholders or members sued may have had no role in the decisions that led to liability. Why should a few passive shareholders or members be liable when the reasons for the company's failure to pay are attributable to decisions made or actions taken by others without their knowledge or participation? Neither BCL Section 630 nor LLCL Sections 609(c) and (d) distinguish among the ten largest shareholders or members based on culpability. The ten largest shareholders or members are liable without regard to whether they are active or passive owners, or whether they caused or were even aware of events that resulted in non-payment of wages. The law also poses a dilemma when more than 10 shareholders or members make equal investments in the company, or if some of those shareholders live out of state. As one author wrote:

"If the tenth, eleventh, and twelfth largest shareholders all own an equal amount of stock, who then is liable? And if some of the ten largest shareholders live out of state, the New York resident, because he alone is subject to service of process, could be held solely liable. This difficulty is tempered by the right of contribution but the enforcement of contribution would still necessitate suing in another jurisdiction." 18 Moreover, why is BCL Section 630 limited to closely held corporations? A corporation whose shares are publicly traded can also fail.

Other Exceptions to Limited Liability Protection Limited liability is universally recognized for corporations and limited liability companies in the U.S. today, with specific exceptions. Corporate shareholders and limited liability company members can be personally liable for their company's obligations in three ways: (i) They may sign a personal guaranty, which is commonly done when a small company leases premises or takes out a bank loan. (ii) They may have acted in a way that allows the claimant to "pierce the corporate veil". Or (iii) they may fall within the scope of a sanction under a specific statute. For example, the Securities Exchange Act, the Internal Revenue Code and the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), impose liability on individuals at fault regardless of the entity's limited liability protection. In New York and throughout the U.S., courts have used the doctrine of piercing the corporate veil to hold shareholders and limited liability company members personally liable for their own wrongdoing in appropriate cases, notwithstanding the general principle of limited liability. Veil-piercing typically requires fraud on the part of the shareholder or member defendant as well as a disregard of corporate formalities, inadequate capitalization, commingling of assets or the personal use of corporate funds. Veil-piercing is a well-known doctrine that targets wrongdoers.19 Other Laws Protecting Employees The need for wage protection was far greater in 1848, when New York first specifically enacted legislation to protect employee wages, than it is today. Back then, lawmakers could not have imagined the range of federal and state labor laws that protect workers today. These laws include the Fair Labor Standards Act of 1938 (FLSA),20 which establishes the minimum wage, overtime pay, recordkeeping requirements, and youth employment standards. The FLSA defines "employer" broadly, imposing personal liability where an individual has operational control of the dayto-day management.21 The Employee Retirement Income Security Act of 1974 (ERISA) sets minimum standards for worker pension and health plans. The Bankruptcy Act gives employees a priority claim in bankruptcy proceedings for up to $10,000 in wages earned within 180 days of the bankruptcy filing.22 New York State law also aggressively protects workers' wages. The Wage Theft Prevention Act, which became effective in 2011, added remedies such as the ability to collect double damages for wage violations. The legislation enacted in 2014 that amended LLCL Section 609 to make the ten members with the largest percentage ownership interest personally liable for wages and salaries of employees also included changes in New York labor law.23 One of those changes was to create successor liability that makes it more difficult for a company to restructure or to dissolve and create a new entity in order to avoid wage liability.

Schedule A BCL Section 630 (2015 and 2016 changes marked) (a) The ten largest shareholders, as determined by the fair value of their beneficial interest as of the beginning of the period during which the unpaid services referred to in this section are performed, of every domestic corporation (other than an investment company registered as such under an act of congress entitled "Investment Company Act of 1940"), or of any foreign corporation, when the unpaid services were performed in the state, no shares of which are listed on a national securities exchange or regularly quoted in an over-the-counter market by one or more members of a national or an affiliated securities association, shall jointly and severally be personally liable for all debts, wages or salaries due and owing to any of its laborers, servants or employees other than contractors, for services performed by them for such corporation. Before such laborer, servant or employee shall charge such shareholder for such services, he shall give notice in writing to such shareholder that he intends to hold him liable under this section. Such notice shall be given within one hundred and eighty days after termination of such services, except that if, within such period, the laborer, servant or employee demands an examination of the record of shareholders under paragraph (b) of section 624 (Books and records; right of inspection, prima facie evidence) of this Article, such notice may be given within sixty days after he has been given the opportunity to examine the record of shareholders. An action to enforce such liability shall be commenced within ninety days after the return of an execution unsatisfied against the corporation upon a judgment recovered against it for such services. The provisions of this paragraph shall not apply to an investment company registered as such under an act of congress entitled "Investment Company Act of 1940." (b) For the purposes of this section, wages or salaries shall mean all compensation and benefits payable by an employer to or for the account of the employee for personal services rendered by such employee. These shall specifically include but not be limited to salaries, overtime, vacation, holiday and severance pay; employer contributions to or payments of insurance or welfare benefits; employer contributions to pension or annuity funds; and any other moneys properly due or payable for services rendered by such employee. (c) A shareholder who has paid more than his pro rata share under this section shall be entitled to contribution pro rata from the other shareholders liable under this section with respect to the excess so paid, over and above his pro rata share, and may sue them jointly or severally or any number of them to recover the amount due from them. Such recovery may be had in a separate action. As used in this paragraph, "pro rata" means in proportion to beneficial share interest. Before a shareholder may claim contribution from other shareholders under this paragraph, he shall, unless they have been given notice by a laborer, servant or employee under paragraph (a), give them notice in writing that he intends to hold them so liable to him. Such notice shall be given by him within twenty days after the date that notice was given to him by a laborer, servant or employee under paragraph (a).

Schedule B LLCL Section 609 (a) Neither a member of a limited liability company, a manager of a limited liability company managed by a manager or managers nor an agent of a limited liability company (including a person having more than one such capacity) is liable for any debts, obligations or liabilities of the limited liability company or each other, whether arising in tort, contract or otherwise, solely by reason of being such member, manager or agent or acting (or omitting to act) in such capacities or participating (as an employee, consultant, contractor or otherwise) in the conduct of the business of the limited liability company. (b) Notwithstanding the provisions of subdivision (a) of this section, all or specified members of a limited liability company may be liable in their capacity as members for all or specified debts, obligations or liabilities of a limited liability company if (l) a statement to such effect is specifically contained in the articles of organization of the limited liability company and (2) any such member so liable shall have (i) specifically consented in writing (A) to the adoption of such provisions or (B) to be bound by such provision or (ii) specifically voted for the adoption of such provision. The absence of either such statement in the articles of organization or such consent or vote of any such member shall in no way affect or impair the ability of a member to act as a guarantor or a surety for, provide collateral for or otherwise be liable for, the debts, obligations or liabilities of a limited liability company as authorized pursuant to section six hundred eleven of this article. (c) Notwithstanding the provisions of subdivisions (a) and (b) of this section, the ten members with the largest percentage ownership interest, as determined as of the beginning of the period during which the unpaid services referred to in this section are performed, of every limited liability company, shall jointly and severally be personally liable for all debts, wages or salaries due and owing to any of its laborers, servants or employees, for services performed by them for such limited liability company. Before such laborer, servant or employee shall charge such member for such services, he or she shall give notice in writing to such member that he or she intends to hold such member liable under this section. Such notice shall be given within one hundred eighty days after termination of such services. An action to enforce such liability shall be commenced within ninety days after the return of an execution unsatisfied against the limited liability company upon a judgment recovered against it for such services. A member who has paid more than his or her pro rata share under this section shall be entitled to contribution pro rata from the other members liable under this section with respect to the excess so paid, over and above his or her pro rata share, and may sue them jointly or severally or any number of them to recover the amount due from them. Such recovery may be had in a separate action. As used in this subdivision, "pro rata" means in proportion to percentage ownership interest. Before a member may claim contribution from other members under this section, he or she shall give them notice in writing that he or she intends to hold them so liable to him or her. (d) For the purposes of this section, wages or salaries shall mean all compensation and benefits payable by an employer to or for the account of the employee, servant or laborer, for services performed by them for such limited liability company. These shall specifically include but not be limited to salaries, overtime, vacation, holiday and severance pay; employer contributions to or payments of insurance or welfare benefits; employer contributions to pension or annuity funds; and any other moneys properly due or payable for services rendered by such employee, servant or laborer, including any concomitant liquidated damages, penalties, interest, attorneys' fees or costs.

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